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When will the bond market wake up

by Brad Setser
January 25, 2005

I know, I know, Morgan Stanley’s investors have spoken, and there is no bond market bubble.

But the federal government certainly is swimming in a sea of red ink.

I hope we have asked the Bank of Japan, the People’s Bank of China, the Central Bank of China (Taiwan), the Bank of Korea, the Reserve Bank of India, the Bank of Russia, the Monetary Authority of Singapore, the Monetary Authority of Hong Kong, the Bank of Mexico and many others to up the limit on our credit card. Alas, our bankers may not be thrilled to be asked to keep on financing us: the US government only pays 4.2% (less for short-term money), a far cry from what American banks charge to Americans wanting to borrow just a bit more on their credit cards.

A while back there was lots of talk about how FY 05 budget deficit would be smaller than the FY 04 budget deficit. I certainly remember this piece by David Greenlaw of Morgan Stanley. Well, the administration now estimates the deficit at $427 billion, including the their latest war supplemental. Last I checked, that is more than the $412 billion FY 2004 deficit. A strong economy and a rising deficit – that is what happens when you try to fight the Global War on Terror on the cheap. Why should anyone take the Bush Administration’s talk of controlling the deficit seriously until they start delivering?

Some think the Administration is back to playing expectation games, and that they have swung from underestimating the FY 05 deficit to overestimated it.

The White House deficit estimate is too high, said Drew Matus, senior economist at Lehman Brothers Inc. in New York. “Given spending initiatives, anything above the CBO estimate of $400 billion including Iraq is too high,” Matus said. It is “better to be too high and announce a positive surprise than too low and adjust higher,” Matus said in an e- mail.

Maybe — the CBO estimated the FY 05 deficit at $370 billion, and they officially estimate than continuing “war spending” at the FY 04 pace would only add another $30 billion to their overall estimate, bringing the deficit up to $400 billion. I think that works out to spending about $60 billion for the year, or around $5 billion a month, on Iraq and Afghanistan. I suspect that is a bit too low; we probably will need to spend more in Iraq this year than last year. The insurgency is not getting weaker. $370 billion + $80 billion, or $450 billion, may be too high: it implies FY 05 spending $105 billion in Iraq and Afghanistan, or about $9 billion a month. We will see — $420-430 billion actually seems like a reasonable estimate to me.

And remember, this deficit comes at a time when the interest rate the US government is paying on its debt (thanks in part to a bit of strategic maturity shortening) is unusually low.

The CBO’s official long-term forecast is not really even worth discussing: the CBO, by law, had to assume all the tax cuts expire at the end of 2010, and that discretionary spending falls in 2006 and 2007 because the end of war-related supplementals lead to sharp falls in defense spending. More realistic forecasts, including the informal forecast delivered by the CBO’s director in his briefing today, imply deficits of $350 billion or more from now on. Here is one way of thinking about the likely future course of the deficit. Revenues are likely to stay at roughly 17% of GDP if the tax cuts are made permanent (the CBO estimates revenues of 16.8% of GDP this year). Mandatory spending is likely to stay at around 10.8% of GDP for a few years (before really increasing after 2010). Discretionary spending — including defense spending — will probably stay in the 8.0% of GDP range, barring a big fall off in defense expenditures (CBO forecasts 7.6% of GDP, but the supplemental will increase that to between 7.8%-8.3% — depending on whether it is a net +30 or a net +80). That allows for some rise in defense/ homeland security spending to be offset by some cuts in non-defense spending. Our interest bill is likely to rise by 0.4-0.5% over the next few years, to 1.9% of GDP (it could well rise much more — the CBO’s forecast for interest expenses assume that falling deficits stabilize the US “publicly held” debt to GDP ratio at 38%; if higher deficits than the CBO forecasts push the debt to GDP ratio rises to say 42%, the interest bill would go up to 2.1% of GDP). Those assumptions push spending up to over 20.7% of GDP, barring any offsetting changes — and generate estimated deficits in the 3.5-4.0% of GDP range. 3.5% of estimated GDP is $526 billion, about two times the Administration’s ridiculously convoluted FY 2009 deficit target.

One last note: Social Security is running a major surplus, keeping the deficit a lot smaller than it otherwise would be. I am all in favor of proposals to end the practice of netting out social security’s surplus from the consolidated budget, to present a better picture of the government’s true finances. That picture is not pretty: think deficits of $600 billion, or 4.9% of GDP, in 2005, rather than $430 billion, 3.5% of GDP. Try doing the present value of 5% of GDP “on budget” deficits forever … I guarantee you it is a lot more than the $10 trillion present value hole in Social Security. The cash flow deficits creating that present value hole don’t start til 2042, or 2052, and even then they are much smaller, as a share of GDP, than the United States’ current structural fiscal deficit.

42 Comments

  • Posted by Roger Senserrich

    Great post, as usual. Thanks.

    Aren’t the expenses in Afganistan decreasing, by the way? I haven’t seen much military action there lately in the news.

  • Posted by L

    Why bother with the absurd budget games about SS? Pension accounting is not rocket science.

    Cash budgets, like the US uses, are considered fraudulent for corporate use — for good reason.

    Put Gov’t accounting on a GAAP basis (there is already a version for gov’t unique needs).

    It will probably not happen, as the deficit jumpts into the trillion-range — per the somewhat vague notes in the published budget.

    That means that on a “real” basis we never had a surplus during the 1990s. The Gov’s pension/medicare liabilities always grew faster than the fabled SS “surplus.”

    That means most of the discussion — on both sides — of the SS reforms is … unreal.

    It’s a political debate, and in 21st century America that means that both sides manuver for personal advantage, neither wishes good accounting and necessary structural reform. (the second requires the first).

  • Posted by DF

    If deflation is what awaits us, then the bond markets are priced in a logical way.

    If anyone can explain me how inflation is possible when the amount of debt falls… Then please do.

    I think everybody is starting to realise that the ratio debt/revenue can not increase forever.
    And that is deflationist.

  • Posted by anne

    Wonderful post as always. These posts and conversations are truly valuable and you writing is a joy to read.

  • Posted by anne

    Politics aside, by which lights the bond market will never wake, this is a most dangerous bond market. The Vanguard Long Term Bond Index has a duration of 10 years. A 1 percentage point change in long term rates will result in a 10% change in price of fund. So, a 1 point rise in long term rates will cost an investor 2 years of earnings. Intermediate Term Bond Index has a 5 year duration. Short Term Bond Index a 2 year duration.

    Commodity prices are in a 2 year increase, and oil bounces from 45 to 50 dollars a barrel. Food and energy prices may not be part of the core price indexes, but they are contributing to a modest rise in inflation along with the weaker dollar. Asset prices are high.

    The federal deficit is simply not going to decline meaningfully. Remember, the Alternative Minimum Tax must be set aside again this year to avoid increasing harm to middle class households. So, the deficit and low household saving rate will continue balance of trade pressure and we become ever more dependant on imports of capital.

    Interest rates? There will be a time when long term rates finally begin to rise meaningfully. Who can say when, but we should indeed be cautious as investors and rather worried.

  • Posted by anne

    Note: The New York Times has just made email of articles much harder. What are they thinking; are they thinking? Every family member subscribes to the New York Times, why make sharing articles by email more difficult? Good grief.

  • Posted by Andrew Boucher

    I vote for (American) inflation rather than deflation, given that Americans are debtors and foreigners creditors.

  • Posted by anne

    Bond funds certainly are pricey. Then how are investors to fare in this bond market? Do we simply buy short term bond funds and settle for low returns to protect principle? I moved from Vanguard long term bond funds finally to intermediate. This bull market in bonds has given us a fabulous 5 years. We averaged a shade below 10% a year, while the S&P has a negative return these 5 years. The price of bonds is a serious matter for investors, especially older investors. Now what?

  • Posted by DF

    It’s easy to vote for inflation.
    But the question remains : how do you make it happen ?
    Inflation does not happen at the snap of the fingers.

    In order to have inflation you need :
    1 to create money
    2 to have wages rise faster than productivity so that that money goes into inflation of goods and not into inflation of assets.

    But :
    how can you create money once you need to reduce the debt level ?
    You can’t.
    How can you have wage rises faster than productivity once you destroyed all meaningful labor legislation and unions ?
    You can’t. THe best you can do is have productivity fall faster than payroll.

    Japan has been trying to fight deflation and has failed.
    The USA can only fare worst because they are much more indebted and have no margin at all. (Japan is exporting, has lots of savings, back in 1990 its government budget was sound…)

  • Posted by glory

    “When will the bond market wake up?”

    i hearken back to billmon’s wonderful exposition a couple years ago(!?) on the ‘economic limits of empire’.

    if you look at CBs as subsidising US ‘imperial adventure’, it’d prolly last until it lands on their shores… so as long as it (and its knock-on effects) is limited to relatively marginal players in global debt markets, you’re only likely to see ‘switching’ at the margin… so far, smooth sailing :D

    [a corollary to my wild-ass speculation of which i have no expertise is that maybe iran, instead of pouring resources into its nuclear program, should buy lots and lots of treasuries instead, thus ensuring itself of ever being invaded - purchasing as it were, the sword of damocles, or at least a partial interest :]

    so i’m not sure the political leverage that large treasury holdings provide to countries has been overlooked? and i’m one who tends to discount the military aspect behind the ‘world’s reference currency’, but maybe there is something more to it afterall?

    cheers!

  • Posted by anne

    http://www.nytimes.com/2005/01/26/business/worldbusiness/26yuan.html

    Growth Up and Inflation Down in China
    By KEITH BRADSHER and CHRIS BUCKLEY

    HONG KONG – Economic growth in China accelerated to 9.5 percent in the fourth quarter, computed from the year-earlier period, while inflation slowed, the National Bureau of Statistics said Tuesday. Chinese officials promised to maintain controls on speculators, but took no new measures to temper economic growth.

    But just nine months after the Chinese economy seemed on the verge of an upward spiral of higher wages and prices, Beijing appears to have kept growth at a brisk pace while bringing inflation under control. Still, private-sector and academic economists are deeply divided over whether inflation can remain low, as Chinese leaders have eased some of the controls they imposed last spring.

    Growth had declined to 9.1 percent in the third quarter, compared with the year-earlier period, and had been expected to fall further in the fourth.

    The growth rate for all of 2004 was also 9.5 percent, despite the government’s stated goal of lowering growth from the 9.3 percent pace of 2003 to try to calm inflation.

  • Posted by anne

    Actually Americans are creditors not debtors. Americans collect more interest income than they pay, and inflation is precisely what we do not need. Millions of retirees especially depend on interest income. Controlling inflation is essential.

  • Posted by anne

    http://www.nytimes.com/2005/01/26/business/26prop.html?pagewanted=all&position=

    Echoes of the 80′s: Japanese Return to U.S. Market
    By TERRY PRISTIN

    Japanese investment in United States real estate soared in the 1980′s, as companies and financial institutions poured nearly $300 billion into high-profile properties like Rockefeller Center in New York and the Pebble Beach Golf Club in California. But the value of many of these assets plunged by as much as 50 percent in the early 90′s, and for more than a decade, the Japanese have been sellers rather than buyers.

    After a 15-year hiatus, however, Japanese capital is re-entering the United States market, but much more quietly and cautiously this time. “They have begun to test the waters again,” said Bill Collins, who runs the capital markets group at Cassidy & Pinkard, a real estate services firm in Washington.

    For the first time in years, for example, Mitsui Fudosan, Japan’s largest real estate company and the owner since 1986 of 1251 Avenue of the Americas, the former Exxon Building, is searching for other buildings to buy in the two most competitive markets in the United States, said Michael W. McMahon, a senior vice president. “We’re targeting Midtown Manhattan and Washington, D.C.,” he said.

  • Posted by brad

    DF — Look at the bond market association tables, or the fed release h 1.3 (or maybe 3.1). Alan Greenspan has not had much trouble creating money by buying government bonds for cash over the past few years …

    Glory — interesting thoughts. i have been trying to think about the political leverage from large treasury holdings too. here is what i have dreamed up:

    1) the leverage that comes from the threat to stop new buying at the margin …
    2) the leverage that comes from the threat of dumping your treasuries, and buying euros (or, in a subtle but clever twist, dumping long-term treasuries for dollars cash — a buyer’s strike).
    3) the leverage that comes from the ability to sell your existing holdings of euros (or yen) and buy dollars to limit the impact of 1) and 2) on the US.

    Thinking about it this way led me to conclude that maybe Taiwan should hold tons of euros — that way it could step in if Beijing ever started selling to put pressure on the US over Taiwan …

    And then there is the broader question of whether China prefers Treasuries or oil fields, long-term, and such issues. I want to write something about the Pentagon’s New Map and this — but i keep getting distracted … or perhaps I am just deterred by the thought that Billmon will be able to produce a more pithy and witty distillation of my long-winded prose in the comments section.

    I do think though, that if china ever got concerned that it was financing a US military buildup directed at containing China (or deterring China from every seeking regional primacy) it might reevaluate its support for the US government’s borrowing. But so far, it has been happy to subsidize US impermial adventures (misadventures) in the middle east, and concentrate on building up its manufacturing base (and increasingly it ownership stake in the world’s natural resource base). Will that continue? or is there a tipping point, where the costs to china of holding all those depreciating dollars exceed the gains? That is the $1 trillion question (almost literally — we need almost a trillion dollars a year in external financing, by the end of the year China will have almost a trillion dollars of reserves if things keep on going as they have.)

  • Posted by anne

    Thinking of inflation:

    http://www.nytimes.com/2005/01/26/business/26rahr.html?pagewanted=all&position=

    Making a Fortune by Wagering That Drug Prices Tend to Rise
    By STEPHANIE SAUL

    Stewart Rahr’s new $45 million East Hampton estate, the most expensive house ever purchased in New York State, is just across the pond from Steven Spielberg’s. Mr. Rahr plays golf with Donald Trump and practices putting on an indoor green in the basement of his warehouse in Queens. He and his wife, Carol, last drew attention in 2003 when they bought four works of art, including a Renoir and a Picasso, in one sitting at Sotheby’s.

    But as he becomes increasingly visible as one of New York’s wealthiest men, Mr. Rahr, a 58-year-old law school dropout, is girding himself for the elimination of the system that helped generate his fortune. His success offers a rare glimpse into a lucrative but little-known corner of the pharmaceutical industry – the once-mundane business of delivering drugs from manufacturers to pharmacies.

    Over the last 20 years, the packing and shipping of drugs evolved into a game of arbitrage, called speculative buying, with distributors like Mr. Rahr wagering on drug price increases.

  • Posted by anne

    Jonathan Spence is a superb thinker and writer:

    http://www.nytimes.com/2005/01/26/opinion/26spence.html?ex=1107752400&en=235668be986000ee&ei=5070

    Martyr Complex
    By JONATHAN SPENCE

    New Haven — WHY has the Chinese government been so intent on showing that the former Communist Party chief Zhao Ziyang was a man of no significance, a man whose life should not be celebrated and whose death should pass unsung? The answer that comes most readily to the historian’s mind is that Mr. Zhao played a role that has often made Chinese governments deeply uneasy: that of a bold and visionary reformer who insistently calls for change and openness in a tightly controlled political environment. Saluted for a time as one of the leaders of the country, Mr. Zhao sought to use his power and visibility to grant a hearing to the voices of those excluded from the inner circles where decisions were normally made. And when he persisted in this course in the face of opposition from senior leaders in his party, he had to be discarded.

    Many others have played similar roles in China’s long history, from as early as the seventh century B.C. Ancient texts suggest a tendency for historians to personalize the idea of reform, to let one or a few individuals give a human face to inchoate and broad-based pleas for change and innovation. Often, those seeking reforms were punished by their own colleagues, so that the concept of reform led to the construction in China of an elaborate and emotionally powerful martyrology.

  • Posted by glory

    yeah, like the mantra for aspiring world powers should be “make debt bo(nd/mb)s not war^H^H^Hnuclear ones1!” sorry, that’s my pith allotment for the day :D

  • Posted by glory

    hey, just remembered this line… “he who can destroy a thing, controls a thing” – paul muad’dib, :Dune

    cheers!

  • Posted by glory

    looks like robert feldman has put a lot more thought into this :D

    http://www.morganstanley.com/GEFdata/digests/20050126-wed.html

    The main risk lies not in the degree of US centrism, but rather in the willingness of countries to cooperate…

    My group developed a scenario analysis framework (the type made famous by my colleague Eric Best), with the degree of America centricity on one axis and the reaction to it — either more cooperation among countries or less cooperation — on the other axis. The four possibilities generated very different worlds for investors…

    cheers!

  • Posted by Ian

    Morgan Stanley GEF page has been excellent this week. The fact that most of the investors attending the macrovision conference agreed that there was no bond bubble is ridiculous. The fact that the 10 year is only yielding 4.17 is suprising given the level of deficits currently being run by Bush. But it is symptomatic of the bond market as a whole. Spreads are record tight across the board, and some truly poor quality junk is trading way way above par.

    One great example is that last year (2004) was the highest level of new issuance for C and Caa rated bonds ever (15.5% of total corporate issuance). Caa can be freely translated as “definitely, definitely going to default.” The survival rate of C rated bonds after five years is something like 30%. The bond market has compeletely forgotten how to do any sort of credit analysis, all the way up and down the curve and up and down in risk from treasuries to junk to soveriegns.

    While the impact of central bank buying in treasuries and agencies can not be discounted, it is private investors who are stupidly reaching for yield in the junk market. A consequence of too much liquidity from Mr. Greenspan and the carry trade, methinks….

  • Posted by anne

    “Not” the bond market really. Repeatedly as interest rates have declined since 1981 there have been marketing pushes by mutual fund companies to attract investors to high yield bond funds. Money flows to junk bond funds for the extra yield, while managers of the funds reach for yield by buying lower quality junk. Time passes, and there is sell off in the high yield market and losses are startling. Time passes and the cycle begins again. The brokerage houses are special abusers of high yield funds. They market the funds, money flows in and the managers buy issues that the brokerage represents.

  • Posted by anne

    Wish to find how dangerous brokerage house high yiled funds are? Look before and after August 1998.

  • Posted by Ian

    Good point. There is also the influence of hedge funds using OPM financing looking for returns today to make performance fees and not particularly concerned about what happens in a couple of years…

  • Posted by Andrew Boucher

    Anne says: “Actually Americans are creditors not debtors.”

    “The broadest measure of the amount the United States owes the rest of the world – the net international investment position or NIIP – has gone from negative $360 billion in 1997 to negative $2.65 trillion in 2003. At the end of 2004, we estimate the net international position will be negative $3.3 trillion.”

    Anne also says: “Controlling inflation is essential.” Well, inflation may turn out to be the best of a lot of bad options. On average, given the fact that Americans are net debtors, it could be better for Americans to tolerate inflation.

  • Posted by Andrew Boucher

    “I do think though, that if china ever got concerned that it was financing a US military buildup directed at containing China (or deterring China from every seeking regional primacy) it might reevaluate its support for the US government’s borrowing.”

    So what is China going to do? If it tried to sell Treasuries (or maybe just not put any more in), Treasuries would tank. The Chinese would be sitting on a huge loss, mark-to-market.

    And if they tried to take their money out of dollars into something else – again big loss.

    If you can’t pay the bank 1000 dollars, then it’s your problem. If you can’t pay the bank 100 M dollars, then it’s the bank’s problem.

  • Posted by anne

    Households earn more in interest than is paid in interest. By household, we are creditors not debtors, and more than moderate inflation will hurt us. Inflation will hurt us in many ways and is be no means a benign solution to federal government debt.

  • Posted by anne

    No question, we are net debtors as a country. Our grandparents and parents however are not net debtors, and they must be protected.

  • Posted by brad

    Ian – great comments. One question, which reveals my ignorance: OPM = other people’s money? Or a technical term?

    Andrew. If you are in a hole, the first step is to stop digging. Am not so sure China worries as much about mark to market losses as we sometimes think. They are gonna lose in renminbi terms no matter what, they must be expecting that. And they don’t have to mark to market if they do not want to — they are the ultimate buy and hold investor if they want to be. why not wait til the two or five year treasury bond matures and get out at par — they cannot sell out easily in anycase, and they can afford to be patient, at least with their treasuries (maybe less so with agencies).

    At some point China might conclude that taking its losses now (and limiting its future losses) makes more sense that waiting, and taking its losses later. I suspect that politics as well as economics would enter into the PBOC’s calculations.

    It seems to me that people make two very different arguments re: China. On one hand, some say China does not care about losing money/ paper losses in the central bank, so it will keep building its reserves, buying dollars and offsetting the treasuries on its balance sheet with renminbi sterilization bonds even though this means China’s future losses shoudl the renminbi rise v. the dollar will get much bigger. I.e. China doesn’t worry about market losses becuase of currency moves (these losses are potentially enormous by the way), it cares much more about keeping its current growth strong (see general glut’s weblog/ bretton woods two authors for this argument)

    On the other hand, some argue that China cares so much about the market value of its reserves (in $) that it will not only hold on to its existing stock of dollar bonds, no matter what, but that it will keep adding to its stock of bonds to support the market value of its existing stock (effectively, a fancy form of evergreening — China lends the US money so the US can stay current on what it owes China, only in this case, China lends the US money to support the valuation of its existing bond portfolio). That argument implies China cares so much about current market values and mark to market losses that it will take aggressive actions to avoid incurring losses now, even at the risk of adding to its future losses.

    I am not sure both points of view can be simultanously correct: either you don’t care about future “paper” losses and are comfortable borrowing renminbi to lend in dollars, or you do care about “paper” losses on your existing treasuries, and such concerns will shape your portfolio decisions …

    I suspect the truth is probably some where in between. under some circumstances, China would be prepared to incur mark to market (paper) losses now rather than later, particularly if taking the losses now was seen to serve China’s interest

  • Posted by Andrew Boucher

    “Households earn more in interest than is paid in interest. By household, we are creditors not debtors, and more than moderate inflation will hurt us.”

    Households aren’t everything. Government pays interest (and doesn’t receive any), but eventually it’s our taxes which goes to pay the government to pay that interest.

    “Our grandparents and parents however are not net debtors, and they must be protected.” So raise their Social Security payments. Anne, what I’m saying is pretty obvious. Except if there are secondary effects (which you are not mentioning), a net debtor (which the average American is) is bettor off if there is inflation. Of course some individual Americans will be creditors and would do badly should there be inflation. As long as they can be compensated by transfer payments (as I am allowed to do with my magic wand), all Americans would be better off – or at least, no worse off – with inflation (again, not taking into account secondary effects).

  • Posted by Andrew Boucher

    Brad – Never underestimate the psychological inability to take a loss. My wife refuses to sell stocks which are worth less than when she bought them. Why? Because (as she says) then she would have lost money. If she holds onto them, she’s convinced she hasn’t lost money.

    Sure, logically it would be better for the Chinese to take their losses now than to take them later. But faced with the choice of taking a certain (huge) loss now or of hoping that something turns out in the future to make everything right, most individuals choose the latter.

    Here’s another way to look at it: I think the Chinese government is over-all pretty pleased with the way things are going in their economy. China (or at least the parts of it government officials are likely to know) is booming – lots of new buildings, lots of TV sets. I would think a rational Chinese would conclude that the present system, which includes accumulating dollars, is sound and sensible.

    But what if there is a sudden blow-up with the US over Taiwan? The main loser of China trying to quickly dump US Treasuries or currency would be China, and the main winners would be, first, American and European investment banks, who would front-run like they’ve never done before, and second, Europeans, who would only be too happy to buy the dollar for 50 euro cents. Yes maybe there would be a financial panic in the US, but then there would be a financial panic everywhere else, including China. So what’s the point?

    China is in a hole, even more than the US is in one. Ditto for Japan.

    Anyway, these are all (obviously) opinions and I could be completely wrong about any one or all. Keep up the good work on the blog !

  • Posted by anne

    Thanks Ian,
    Thanks Andrew Boucher,

    Though I want to argue with you Andrew, I am beginning to lean to your side of the argument. [My goodness, did I learn nothing about debating?] Possibly confusing both of us, the last several years I have heard complaints from retirees about the low levels of interest they are earning. Bond funds and bonds for many people are not bought for total return, but for income, and income is quite low. There is a lot of yield chasing going on. Would there actually be relief from private bond and even bond fund holders were interest rates 1 or 2 percentage points higher?

    Oh dear :)

  • Posted by Ian

    Brad- yeah OPM is other people’s money.

    Great comments all, keep it up!

  • Posted by anne

    Ian

    Are junk bonds liquid enough for decent hedge funds? Your note was surprising and interesting.

  • Posted by anne

    Andrew

    Thank you again. I am thinking :)

  • Posted by still working it out

    (sorry for no paragraphs. Can’t get the working)

    Everyone keeps assuming that the only trade that matter’s to China is that with the US. I am not any sort of economist, but the thinking of the Chinese leadership seemed to be pretty clearly laid out by the Chinese President on his tour throughout SE Asia towards the end of 2003. The most interesting thing he emphasised was China’s focus on and the potential of intra-regional trade. He even talked about it in his speech to the Australian Parliament.

    The sub text seemed to be that if Asian nations start trading with each other, rather than relying on exporting to the US, then they can all grow together as Europe has done instead of playing a race to the bottom to meet the demands of US consumers at the lowest possible price. A game in which they all lose.

    But intra-Asian trade is not yet strong enough to be self sustaining. So they still need to rely on the US consumer for growth in the meantime.

    When that intra-Asian trade is strong enough China (and the rest of Asia) will be able to give the US dollar the big finger without suffering economic meltdown themselves. The US will suffer and the massive Asian dollar assets will be worth much less, but who cares? The lower value of the dollar assets will be offset by how cheap everything will be in wrecked US economy and the political leverage they will buy. And in the meantime China and Japan will have become the leaders of the greatest economic powerhouse the world has ever known, and most importantly their leadership will independent of outside control from the US or anyone else.

    In short China knows that buying US dollars at this rate is unsustainable and they will inevitably suffer large losses, but they belive they only have to do it for a few more years and the losses are nothing compared to he payoff. It may be true, but it is a race between how fast intra-Asian trade can develop and how long the US dollar can continue to be supported.

  • Posted by still working it out

    Paragraphs did not work in he preview, did not realise they would come out in the post.

  • Posted by DF

    Brad, of course Greenspan has not had any problem adding new cash in the economy : May I remember you that credit is booming ?
    As long as the debt / GDP ratio increases it is easy to create money.

    The question is when it falls.
    How can you create money when people stop borrowing ?
    You tell me.

  • Posted by brad

    DF — you can create base money by buying government bonds (or other financial assets in extremis) for cash. Now if people hold cash as an asset and don’t put it to work in the banking system and get the money multiplier going, then you have a potential problem (see Japan). But it is not hard to create base money.

    (p.s. if you don’t want to buy bonds, just make a loan to the government to cover its fiscal deficit — monetizing a fiscal deficit is usually a good way to get inflation going; see Latin America at various points in time)

  • Posted by jm

    I have for some time been thinking along essentially the same lines as DF. Because (as I understand it, anyway) the price level depends as much on the velocity of money within the goods-and-services area of the economy* as it does on the money supply, and the supply depends not only on how much the Fed prints but also on how much that quantity is multiplied by fractional-reserve banking (and any functional equivalents), then might it not be possible for transient phenomena in the circulation of money to cause velocity to fall faster than money supply can rise, forcing GDP and/or the GDP price deflator to fall despite rising money supply.

    Could a breakdown in money recirculation via foreign central bank dollar debt purchases cause such a velocity drop?

    And if a side effect of such a drop in velocity were to be upsets in the fractional-reserve banking multiplication rate, could that start a regenerative deflationary spiral?

    I’m sure that by macroeconomic theory the above would be impossible, because some offsetting market reaction would come into play. But macroeconomic theory also says that the kind of trade imbalances we now see are not possible, because markets will adjust exchange rates to remove them. But the whole reason we are talking about this is that central banks have utterly corrupted and crippled the market mechanisms, so why should we blithely assume that market mechanisms will prevent this?

    If delation takes hold, it may be devilishly difficult to stop. The idea that inflation is inevitable permeates our society, and there are numerous mechanisms in place to coexist with it and exploit it. How well will those mechanisms function in a delationary environment?

    I still remember vividly the moment when some young Japanese friends told me they were thinking of buying a condo, but had decided to wait a few years, because the longer they waited the cheaper they would be.

    *My understanding being that, by definition:
    velocity=(GDP*GDP_price_deflator)/money_supply
    and
    money_supply*velocity=GDP*GDP_price_deflator

  • Posted by DF

    DF — you can create base money by buying government bonds (or other financial assets in extremis) for cash. Now if people hold cash as an asset and don’t put it to work in the banking system and get the money multiplier going, then you have a potential problem (see Japan). But it is not hard to create base money.

    OK brad, you agree with us then. If people don’t spend the money, nor lend it, then the increase is useless. Your money multiplier falls.

    The central bank is not the main creator of money. Most of money creation is made by private banks. Let’s say 90%.

    So if your money multiplier falls because
    1 banks do not want to lend (all the potential clients are overleveraged, the risk is too high)
    2 clients do not want to borrow (they are overindebted, and betting on price falls).
    Then the amount of money falls. Whatever the federal bank does.
    More base money does not pave the way to more money in the economy. The central bank prints, and injects huge amounts of base money. But that money is stored, and private banks start to destroy their own money.

    The only player that keeps having some borrowing power is the government. So of course the government can increase deficits and force the central bank finance them with money creation.
    In fact that’s the best solution.
    (The japanese have applied it too. And so far it has not been enough.)

    The problem with the USA is that I doubt the government could increase much its deficit without losing lots of credibility.
    If it were to finance its own deficit through money creation in a visible way, the government may force a panic, foreigners would move out of the US markets, creating a huge drop on asset prices, thus worsening the situation of households and companies.
    In the long run inflation may follow, but not after a period of initial deflation.

    Phrase it this way : growth is 3.5%, deficit 4% and some part of it may already be financed indirectly by money creation, money expansion is huge, commodities have risen a lot (and oil has risen a lot). And there still is no significant inflation.
    What is to happen if a recession forces commodities down, wages prices down…

  • Posted by Steven Duffield

    “The cash flow deficits creating that present value hole don’t start til 2042, or 2052, and even then they are much smaller, as a share of GDP, than the United States’ current structural fiscal deficit.”

    That is true, which is why the present value estimate for Social Security’s infinite-horizon deficit is closer to $11.9 trillion. Permanent cash deficits begin in 2018 (or 2019) and grow every year thereafter. “Cashing in” special obligation Treasuries costs $1.5 trillion from 2018-2042 (or $2 trillion from 2018-2052) in present value terms. If you choose to depict the future in consolidated budget terms (as you are right to do) you must include the cost of redeeming Trust Fund assets.

  • Posted by jm

    From Andy Xie’s commentary at
    http://www.morganstanley.com/GEFdata/digests/20050124-mon.html#anchor4

    “While virtually everyone at the MacroVision conference was bullish about the yen, one Japanese participant from a big insurance company stood up and begged to differ. ‘The spread between Treasury and JGB is 300 bps. That’s good enough for us to buy’, he said. No one reacted to his comment.”

    “I checked the data afterwards. Sure enough, the average spread between 10Y Treasury and JGB was 299 bps in the past three years. While hedge funds borrow dollars at 2.25% to buy yen with zero yield, Japanese insurance companies are buying US Treasuries with 300 bps yield pickup. With 300 bps pickup, they are better off buying Treasuries against JGB if dollar-yen is higher than 80 ten years from today. Of course, if you listen to some hedge funds, dollar-yen should reach 60 or lower and soon. With dollar-yen at 60, Japan’s per capita income would be 60% higher than the US’s. Have you been to Japan lately?”